Plansmith Blog

Risk is inevitable in banking; in fact, it’s what makes banking profitable. The question is, how much risk is acceptable? Recognizing that existing techniques of measurement were sometimes misleading and arbitrary, Plansmith developed a simple calculation called "Margin Risk Tolerance" that defines how much risk each bank can take. Despite the wealth of banking information Plansmith has at hand, we believe risk relates to the individual bank, and cannot be measured to any peer standard or magic number.

Margin risk tolerance calculates the minimum net interest income and net interest margin necessary to maintain continuing operations. Minimum margin consists of two basic components: 1) earnings needed to maintain an acceptable capital ratio and pay dividends, and 2) earnings needed for overhead.

Why Your Financial Institution Needs a Playbook in 2025

The financial landscape is set to undergo significant shifts in 2025, driven by fluctuating interest rates, evolving economic conditions, and a changing political environment. These factors present both opportunities and challenges for financial institutions, making it essential to have a comprehensive playbook. A playbook not only provides guidance, but ensures that institutions remain agile and focused on key objectives, especially during fluctuating rate environments. While we don’t know how much rates may fluctuate, we do know it’s important to be prepared for any scenario.

What do massive shifts in deposits, economic uncertainty, and falling interest rates have in common? The potential to wreak absolute havoc on your institution’s liquidity position. One unplanned or mismanaged situation could mean falling out of policy limits, or worse.

Over the past several years, the banking industry has seen seismic shifts in deposits as trillions of dollars in Government stimulus were released into the economy, followed by a period of dramatic increases in market rates, which then resulted in massive amounts of low yielding balances migrating into higher-paying CDs and non-bank investment products.

Establishing and maintaining a sound interest rate risk (IRR) management program is crucial to ensure proper balance sheet structure and comply with Regulatory expectations. During my 20+ years as a senior FDIC examiner, I routinely saw organizations experiencing issues with their ALM/IRR practices, ranging from loose misunderstandings of the guidance to critical errors that put the health of the organization at risk. Unfortunately, in my current advisory role, all too often, I see the same issues.

Over the last decade and a half, there has been a sort of dance when it comes to deposit stability. Following the Economic Crisis, we saw a massive “surge” of funds into banks and credit unions as depositors sought safety and a place to “park” money until better returns were again available in the market. In early 2020, after market rates had jumped a bit, I crafted a blog declaring the death of surge deposits, but then quickly had to shift as we saw a new round of “surge deposits” following the Government’s release of trillions of dollars in Covid-related Stimulus funds. Then, as deposit rates shot up in 2023, we saw a massive movement of funds from low-cost checking and savings deposits into higher-yielding CDs and MMDAs. Now, as we near the end of 2024, we’re left with a lot of deposit-related questions. Specifically,

• Is this period of deposit migration finally over?
• How stable are our remaining deposit balances?
• Were our IRR model deposit pricing and decay assumptions right, and/or do we need to make changes in light of historical performance and/or future expectations?
• How much impact do any of these assumptions really have on our model results?

To help answer those questions (ones examiners will certainly be asking), we’d strongly suggest that you be sure that your asset liability management program includes backtesting, sensitivity testing, and decay rate and deposit trends studies.

Are you really planning, or are you just budgeting?

By this I mean, are you filling out the numbers on a spreadsheet or planning the actions needed to make it a reality?

It’s always gratifying when all the numbers come together in a neat package showing expected growth and earnings for next year. And, there were likely many contributors who verbally expressed their goals and plans on how they are going to reach them. The compiled financial targets are then presented to and accepted by the board, and your monthly comparisons begin. Budget “predictions” are compared to reality. Variances from “budget” are explained, and business continues as usual. In essence, that’s budgeting.

Our recent blog discussed Product Profitability, or the process of analyzing your product line by looking at each asset category and adjusting its yield by adding non-interest income, and subtracting applicable loan losses and overhead. The overhead we associated with the asset was its funding liability cost less applicable service charges. This gave us a more heightened awareness of the true earning potential of each earning asset.

As increased competition and consolidation challenge the financial industry, your business must continue to adapt using strategies for success, not unlike those of other businesses.

Manufacturing and retail have long used product management techniques to meet competitive pressures for pricing, product planning, and growth strategies. If financial institutions are to survive and prosper in this highly charged competitive environment, management must understand and control all components of profitability. Margin and equity risks have been addressed using regulatory rate shock methodologies, as well as recommended and required stress testing of the loan portfolio, including loan losses. Product profitability combines these concepts with an often-overlooked element of cost – overhead.

Uncertainty and volatility seem to be the only consistent elements concerning the post-COVID economy. So, how do you adequately measure the financial impact today’s economic landscape will have on your business? By utilizing a true planning model.

A professional forecasting platform for Budgeting and ALM/IRR adapts to changing conditions. As it is relationship-driven, it can be set to react to environmental changes, including rates. As the rate environment shifts, so should your balance sheet growth and product mix. Planning models help you test the impact of such changes and measure results in minutes, not hours.